The emerging markets party may be over

Stocks and bonds in emerging markets like China may already be in a meltdown, analysts warn.

Looking headlong into the possibility of another market meltdown as the result of a so-called taper tantrum, investors may be starting to cut and run from emerging markets stocks and bonds.

A new report from the Institute of International Finance, which lobbies on behalf of banking institutions around the globe, shows a “more challenging landscape” for the securities from emerging countries – those with smaller income levels and less active capital markets such as Brazil, India and Indonesia – moving forward.

In fact, “we’re seeing a bit of a taper tantrum at the minute,” Scott Crawshaw, co-portfolio manager of the Harding Loevner Global and International Funds told Yahoo Finance during a meeting in New York.

The newly stronger U.S. dollar and rising interest rates in the United States are threatening emerging markets in much the same way they did in May 2013. The sell-off in EM assets came after the Federal Reserve said it would begin to phase out its quantitative easing program, pushing investment levels to a floor from which many countries have only recently recovered.

EM equities have struggled this year, with MSCI’s benchmark emerging markets index having fallen more than 10% since its late January peak, following a strong U.S. payrolls report and expectations for faster interest rate hikes from the Fed. However, year-to-date, the asset class is down just 1.4%.

The big loser could be emerging market debt, which has been hard hit as investors pile out with rising U.S. interest rates.

The benchmark JPMorgan emerging market global bond index is down nearly 7% since its late-January high, with more than 90% of that drop having come since April 18. The IIF reported at the end of April that $5.6 billion had flowed out of emerging market bonds and stocks during just the April 16-25 timeframe, as the U.S. 10-year Treasury note yield rose to 3%. It was a sharp turnaround from the strongly positive flows that had gone to the asset class for most of the year.

As a result, IIF’s portfolio tracker showed cash flowed out of emerging markets stocks and bonds for the first time last month since November 2016. A similar reading from Capital Economics found net inflows to the asset class were zero in April, down from around $40 billion in March and from an average of $50 billion for 2018, even with the inclusion of zero inflows for April.

The new developments have prompted IIF to cut its expectations for investment in EM this year by $43 billion.

“The stronger USD and renewed focus on rising U.S. rates has been a paradigm shift for investors,” IIF analysts wrote in a recent note.

Protectionism is bad news for emerging markets

Additional risks include the spread of globalization, which has sparked increased nationalism in a number of countries, including some of the world’s largest economies, analysts at Prudential asset manager PGIM said in a recent report. While the rising tide of nationalism and possibility of increased protectionist policies represents a risk for the countries themselves, it could be a bigger risk for emerging markets said David Hunt, PGIM’s president and chief executive, and Taimar Hyat, PGIM’s chief strategy officer.

“Beyond the potential geopolitical and social disruptions, this escalating tussle between globalization and nationalism could have profound implications for global financial markets, historical investment frameworks and traditional asset allocation approaches,” the two wrote.

As traditional systems have broken down as a result of disruptive technology and movement of human capital across borders, “traditional monetary and fiscal policies, and historical investment frameworks, will be inadequate to understand the shifting economic landscape,” Hunt and Hyat said.

They recommend investors increase diversification, consider alternatives and hedge their bets, even if it’s expensive.

It could be different this time

Even with all the bad news and all the selling, many analysts believe things will be different this time – at least for some countries. A number of central banks have grown more independent, governments have tackled fiscal imbalances and deficits, and capital markets have deepened, they say. That will allow certain countries to avoid the bloodletting that could come from a taper tantrum redux.

“In my view, overall, the risks are lower [now], but that doesn’t mean you can’t get another 10 or 20% fall” in select countries, Harding Loevner’s Crawshaw said, highlighting Brazil, South Africa, Argentina and Turkey. “That could happen. But our natural inclination, when you get a big dislocation [in certain bonds and currencies] is to add a bit more to our quality names. We tend to increase exposure.”

IIF said it expects EM capital flows to shake off the recent downswing and continue to benefit from the global economic upswing, with global growth reaching 3.5% in 2018, up from 3.2% in 2017. They also expect EM growth to rise to 5.2% in 2019 from 5% this year, backed mainly by commodity exporters, including Brazil, Chile, Nigeria, Saudi Arabia and UAE as well as India.

Despite their confidence in the economic fundamentals, IIF noted there were a number of serious risks to a bounce-back from this recent wave of selling and a recovery in EM. Most notably, the organization pointed to continued strength from the U.S. dollar, escalating trade tensions between the United States and China, high levels of debt in many EM countries and political surprises that could come from upcoming elections in Mexico, Brazil, Turkey and a number of other large countries.

The concerns investors have are much different than they were in 2013 and many emerging markets are in much better positions than they were then, Crawshaw said, “but it doesn’t stop people from getting scared.”